Private mortgage insurance (PMI) is one of those straightforward financial things that is often misunderstood. One reason is that generalizations are often presented as hard and fast rules. The ins and outs of PMI can be easily understood in context of the reason for the insurance.
Some Common Misconceptions
The biggest misconception about PMI is that you always need it if you are not putting down 20 percent on a home purchase. Though the 20 percent rule is common, it is not an absolute.
There’s no law; lending institutions make their own rules and they aren’t always the same.
Another common misconception is that PMI somehow protects the borrower. The purpose of PMI is to protect the bank, or other lending institution, in the event the borrower defaults.
It is sometimes a necessity, but other than the lender requiring it or you don’t get funded, it does nothing useful for the borrower.
The last big misconception we’ll talk about is that it will never go away unless you take action. Not true. But it will help to understand when it goes away and when you might want to act.
An Overview
PMI is required by many lending institutions to protect their interests when the loan has a relatively high loan-to-value (LTV). LTV is the ratio of the loan amount to the property’s value. In many cases, lenders use an 80 percent LTV as a cutoff, but there are exceptions.
The purpose is to protect the bank in the event the homeowner defaults on the mortgage. There’s a risk connection here for the bank. Not only is LTV a risk factor, but the borrower’s credit is as well.
There are a number of insurance companies that offer PMI. The lender chooses which one to deal with; you, as borrower, typically pay for the insurance as part of your monthly mortgage payment.
The cost varies depending on the insurer and the borrower’s creditworthiness.
A typical range is from a low of about 0.5 percent of the original loan balance to around 2 percent of the original loan balance each year. Since the PMI is a percent of the original loan balance the size of the mortgage is a major determinant of cost, the next biggest factor is the borrower’s credit.
Note that it is the original mortgage balance that determines the cost; the premium will stay level as long as you have PMI on the mortgage, it doesn’t generally adjust as you pay down the loan.
Loans That Don’t Have PMI
Several common loans don’t have private mortgage insurance, including VA loans. Eligible veterans obtaining mortgages through the Department of Veterans Affairs, are not required to pay PMI. There are origination costs that help cover the lender’s risk.
Federal Housing Administration (FHA) loans also do not have PMI. However, they do have FHA mortgage insurance, which is both an up-front cost and an ongoing monthly cost.
In most cases, the insurance costs of an FHA loan will be higher than those of a conventional loan.
U.S. Department of Agriculture (USDA) mortgages have mortgage insurance that works like the FHA’s, but generally at a lower cost.
Some conventional mortgages don’t have PMI even though the borrower is not putting down 20 percent. These mortgages are more likely to be offered by local or regional institutions, such as credit unions, to attract applicants with excellent credit. They are not generally available to those with low credit scores.
Getting Out of PMI
PMI has some consistency provided by the federal Homeowners Protection Act (HPA). The HPA provides three ways to cancel PMI, two of which are automatic and require no action on the part of the borrower.
Automatic PMI termination occurs when your loan is scheduled to go to 78 percent (LTV), based on the value at time of purchase. In order to qualify for automatic PMI termination, you must be current on your loan payments at that time. If you’re not, automatic termination should occur shortly after you bring the loan current.
Final PMI termination occurs halfway through a loan term. This would generally be later than the 78 percent LTV automatic termination for a conventional mortgage. The final termination cancellation generally applies to nonconventional mortgages, such as interest only or balloon loans.
You can also request PMI termination if you have reached an 80 percent LTV based on your home’s current value. You may have to prove current value through an appraisal or other methodology acceptable to the lender.
This provides an opportunity to get out from under PMI if your home appreciates significantly during the first few years of ownership. It could also come into play if you paid down the principal significantly to get under the 80 percent number.
Alternate Forms of PMI Payments
Borrower-paid private mortgage insurance added to the monthly mortgage payment is the most common scenario. But it isn’t the only way it works. There are three other possibilities.
In some cases PMI is charged up front. This is less likely, as few borrowers with low down payments can afford additional up-front costs — otherwise they’d be able to put down more.
In the case where you are paying PMI up front, you are paying the entire premium and won’t be able to get a refund if you achieve 80 percent LTV sooner than expected.
The attraction to some borrowers is that they may qualify for a slightly larger mortgage without a monthly PMI payment.
There is also lender-paid PMI (LPMI). When the lender pays the PMI, the costs are incorporated into the financing in the form of higher interest and there’s no getting out of the cost of PMI without refinancing.
The final alternative form is a combination of up-front and monthly costs, similar to the FHA and USDA approaches. The attraction here to borrowers is lower ongoing monthly payments compared to having the entire PMI payment in conjunction with the mortgage payment.
PMI and Financial Decisions
Sometimes private mortgage insurance is inevitable. It isn’t always possible to find a lender who will approve the loan without it. And sometimes when they do, the interest rates don’t justify going that route.
Some pundits recommend waiting until you have the typical 20 percent down to escape PMI — this can be costly advice. When real estate trends upward, you could end up paying far more for the same house, eclipsing any savings you might garner from not paying PMI.
In a hot market, real estate may appreciate faster than many people can save for the down payment — they’re not gaining on it even when saving at a significant rate. It many cases, it may be more cost effective to purchase the home you want and pay the PMI.
In that case you should monitor your home’s value and apply to have the PMI removed as soon as possible.
It may be possible to get a mortgage without PMI by purchasing a lower-priced property on which your down payment is relatively larger, making the LTV smaller and lowering the risk to the lender. This can also be counterproductive if your long-term plan necessitates the house you truly want.
Sometimes getting the stepping-stone house can preclude you from ever getting the one you want.
PMI can be expensive. It behooves you to understand how it works and how you can ultimately get away from it. In the final analysis, it isn’t that you always pay the least; it is that you end up with the most. Sometimes you really do have to spend the money to get ahead.
